Public initiatives to support entrepreneurs: Credit guarantees versus co-funding

We analyze state-sponsored credit guarantees in a setting where entrepreneurs are capital-constrained and subject to moral hazard. In our model, guarantees can raise welfare because they reduce the cost of capital faced by entrepreneurs, and so potentially enhance entrepreneurial effort incentives. Overly generous guarantees have perverse incentive effects, however: they induce lenders to reduce lending standards and to lower their collateral requirements. Co-funding schemes do not suffer from the put option feature inherent in guarantees, but they may encourage entry by unproductive entrepreneurs who plan simply to consume subsidies, without investing. This limits the guarantee fund's ability to support productive entrepreneurs, and thereby destroys value. Based on these trade-offs, we show how the optimal design of state-sponsored loan subsidy schemes depends on the fund's technological expertise and the degree of creditor rights protection. We explore the dynamic efficiency effects of public subsidies, and show that they may impair the private sector's initiative to uncover cost savings in order to diminish future financial constraints.